We recently presented a long term chart of the gold-silver ratio. Traditionally it has been a leading indicator of credit spreads, as during times of declining economic confidence silver, which has a large industrial demand component, tends to fall against gold (which is what this ratio depicts, only vice versa).
Our comment below the chart went as follows:
„The 'fly in the ointment' chart. In spite of the big party the markets threw on Friday, the gold-silver ratio has broken through a long term downtrend line this year. This bodes ill for the medium to long term outlook for stocks and junk bonds, as the ratio tends to work as a proxy and leading indicator for credit spreads. Note in this context that junk bond issuance has recently diverged bearishly from the stock market (namely at the early April high in the SPX). This is a phenomenon that was last observed in 2007."
This prompted a reader to ask us to clarify this comment further in an e-mail exchange. We thought it might also be of interest to other readers and our further thoughts on the matter follow below:
Per experience, major trend changes in this ratio precede credit distress with a lead time varying from a few weeks to a few months (as always, this is more art than science). It is a heads-up that 'risk assets' of all kinds could get into trouble as the year goes on, provided the ratio does not reverse convincingly.
Since the AU-AG ratio's peak during the 2008 crash, it has been in a long term downtrend – since the downtrend line has recently been breached, a warning signal is currently held to be operative.
The industrial and fabrication demand for silver has remained fairly constant (or rather, has grown very slowly) over the past decade. The loss of demand from the photography sector was more than made up by demand growth in other sectors. What growth there has been has mainly come from investment demand.
One of the reasons why it makes more sense to use silver than e.g. copper or crude oil for this exercise, is precisely based on the fact that the large above-ground supply of silver held for investment purposes is providing a large supply cushion – this means that the silver market is as a rule not subject to unforeseen supply shocks.
For instance, in crude oil one could imagine a scenario where political tensions in the Middle East drive up its price in spite of declining economic confidence. In copper, it may happen that strikes at very large mines in Chile could prop the price up, a drought might influence grain prices, and so forth.
Platinum, another metal with both precious and industrial metal characteristics is also somewhat less useful for using it in this type of indicator, as its production is highly concentrated in one place (75% of it is produced in South Africa) and supply disruptions are both likely and can not be buffered easily. The platinum market is small and often highly volatile.
This is not the case with silver: for one thing, the bulk of its production is widely dispersed and mostly a by-product of base metal mining, and secondly the large stock held for investment purposes will always be available to offset any major disruptions from the supply side.
Silver is in that sense uniquely qualified to reflect perceptions about future industrial commodity demand. Very occasionally there will be distortions in the price due to an unexpectedly big surge in investment demand, but these are actually quite rare (we could only name two over the entire post WW2 period, and the second one, which happened in early 2011, happened to coincide with waxing economic confidence anyway).
Gold's price on the other hand is almost entirely a function of investment or monetary demand (with reservation demand the biggest component thereof). Regardless of whether gold was 'fixed' against currencies during the gold standard, or whether it was free-floating as it is now, its price has always tended to rise relative to other commodities and goods when economic confidence was waning.
The gold-silver ratio over the past three years: 'QE2' led to a sharp increase in economic confidence; then investment demand increased sharply as new bullion-backed silver ETF's were introduced. Since the end of 'QE2', confidence has been waning again - click chart for better resolution.
On the question whether specific types of credit are by experience more likely to be affected that others by the change in conditions signaled by moves in the gold-silver ratio, we replied that it is not so that one can pinpoint specific spread products as being especially susceptible.
Rather, the Au-Ag ratio must be seen as a more general indicator: it is highly sensitive to changes in perceptions about the economy. Often when it gives either a negative or a positive signal, we will concurrently observe some initial disturbance, respectively signs of betterment, at the edges of the credit markets.
Often these will be things that barely anyone notices. Below are two pertinent charts from a recent report by Elliott Wave International (EWI). The first one depicts the volume of junk bond issuance relative to the price performance of the Dow Jones Industrial Average.
What is important in this chart are the divergences (both at highs and lows). What is noteworthy at the moment is that as in 2007, the demand for junk bonds has receded slightly even as the stock market made new highs (one can also see that the opposite type of divergence occurred near the 2009 lows).
Via EWI, a chart that shows the price performance of the DJIA against the volume of junk bond issuance. At both market highs and lows divergences will tend to occur - click chart for better resolution.
Similarly, the spread between treasuries and industrial bonds graded B has been making a higher low recently. These are only very small signals, and like the Au-Ag ratio signal may yet be invalidated, if these data points change in a positive manner very quickly. But taking all of them together, they represent an early warning signal.
T-note versus B-rated corporate debt spread: diverging again as well – click chart for better resolution.
Regarding which types of credit may come under the most pressure, one could probably simply argue that the lower the credit quality, the greater the pressure will be. Right now, junk bond prices remain extremely strong, so aside from the stress in European credit markets (mainly in sovereigns and banks), the world seems fine.
However, this is always the case when the first warning signs appear: the world is still fine when they do.
In the end, a general case of credit revulsion will likely make its appearance, i.e., the troubles will spread from the corner to which they now seem confined to the rest of the credit world.
Consider in this context also the next chart below: the price of JNK compared to the JNK-TLT ratio. Here we have another divergence that one should classify as a subtle warning sign.
JNK against the JNK-TLT ratio – it is probably no coincidence that this divergence appears while the gold-silver ratio is rising - click chart for better resolution.
One can compare this with what happened from 2007 onward: in the beginning, only sub-prime mortgage debt came under pressure. Officials and their advisors all insisted that the troubles would remain 'contained' to this sub-sector. But they rarely do remain so contained – in the end it is always 'all one credit market' to paraphrase Bob Hoye. The differentiation between various types of credit instruments that the market makes at the moment will increasingly disappear if/when the crisis intensifies and spreads.
One can observe this phenomenon also by studying the behavior of credit default swaps on European and CEE sovereigns over the past three years: whenever the market recovered, perceiving that the crisis was about to end or pause (i.e., every time it appeared that the can had been kicked down the road successfully), the market began to treat CDS on every country differently. Every sovereign debtor was assessed on his own merits and correlations between CDS declined sharply (the 'better credits' saw much bigger declines in their CDS spreads than the 'bad credits').
Whenever the crisis flared up again, correlations immediately began to become much stronger again – individual merit was overruled by contagion fears.
Our advice would be to keep a close eye on the Au-Ag ratio to see whether or not it falls again, and to keep an eye open for all the small divergences or other small 'yellow flags' that may become noticeable in credit markets. If the 'yellow flags' begin to proliferate and the Au-Ag ratio keeps rising or refuses to decline, the probability of a major 'risk off' event sometime later this year must be considered to be very high.
To be precise, 'there was a signal at 125 giga electron volts', no more. The particle equivalent of a quick 'hello there'. It will take a few months of sorting through the data from the historic particle collision to be 100% sure that it was indeed the Higgs Boson that has been spotted. However, nuclear physicists seem quite happy with that little signal and Higgs suddenly looks like a very likely candidate for a Nobel Prize.
The Higgs particle was the missing link in the so-called 'standard model' – it is what supposedly 'lends' the rest of the particles mass, and allowed them to coalesce into galaxies after the 'big bang'. Not only would the discovery complete the standard model, it is also to be expected that closer scrutiny of the data will reveal still more information about the universe.
Unfortunately, as CERN remind us, 'matter makes up only 4% of the universe' (normal matter, that is). So there's still a lot for physicists left to do.
Steven Hawking lost a $100 bet on the discovery of the Higgs (he had bet that the Higgs particle wouldn't be found, but something else 'even more amazing'). Hawking recently held a party for time travelers, mailing out the invitations after the party was over. Nobody showed up, so the laws of causality seem safe for now.
As an aside to all this, gold is the by-product of dying suns – it is only produced in the crucible of a supernova.
There it is….the Higgs Boson drops in.
(Image credit: CERN)
And it was hiding in here all this time…the Large Hadron Collider at CERN